Contract for difference

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A contract for difference (or CFD) is a contract between two parties, buyer and seller, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.) Such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares

Contracts for differences allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities.

CFDs are currently available in listed and/or over-the-counter markets in the United Kingdom, Germany, Switzerland, Italy, Singapore, South Africa, Australia, and most recently New Zealand. Some other securities markets, such as Hong Kong, have plans to issue CFDs in the near future. CFDs are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on OTC financial instruments.

[edit] Charges

The contracts are subject to a daily financing charge, usually applied at a previously agreed rate above or below LIBOR or some other interest rate benchmark. The parties to a CFD pay to finance long positions and (may) receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.

Traditionally, CFDs are subject to a commission charge that is a percentage of the size of the position, usually <0.25%, for each trade. Alternatively, an investor can opt to trade with a market maker, foregoing commissions at the expense of a (usually) larger bid/offer spread on the instrument.

Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (ranging from 1% to 30% usually). One advantage to investors of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to a margin calls in a downturn, which often leads to losing a substantial part of the assets.

As with any leveraged product, maximum exposure is not limited to the initial investment; it is possible to lose more than one put in. These risks are typically mitigated through use of stop orders and other risk reduction strategies (for the most risk averse, guaranteed stop loss orders are available at the cost of an additional one-point premium on the position and/or an inflated commission on the trade).

[edit] CFDs versus futures

CFDs are convenient for the stock market(if used under around 10 weeks ,an estimated point where CFD financing charge for CFD crosses over financing charge for stocks) while futures are preferred by professionals for indexes and interest rates trading (but CFDs for indexes are used too and futures for stocks also). In addition to avoiding stamp duty, increased flexibility and leverage are other advantages of CFDs over more conventional forms of margin trading (like stocks), although with futures there is usually enough leverage available (typically 20:1, but can be as high as 70:1). All forms of margin trading involve financing charges (with the exception of the Spot Foreign Exchange market), although in the case of CFDs and futures contracts these are already embedded in the price of the instrument. On the one hand, futures are more transparent (for instance: a group of hedge funds linked to BAE systems managed to get more than 15% of Alvis through CFDs without having to warn the British regulator, see more in the "virtual positions" section of this IFLR article on Virtual positions through CFDS). On the other hand and that is evidence of their success, CFD-related hedging is estimated to account for more than 25% of the volume on the London Stock Exchange, a fact which corroborates the view that CFDs are recognised as very competitive (and are subsequently widely used) for trading stocks.

[edit] Risk

CFDs allow a trader to go short or long on any position with a variable margin (set by the brokerage) that allows them to trade on margins of up to 5% (and sometimes 1%); lack of appreciation for the sort of exposure that can be experienced from taking full advantage of such financing is hence a crucial reason that many CFD traders lose; whereas a solid money management strategy can allow a trader to take full advantage of CFDs to their benefit; the CFD broker or principal will always be required to mirror the underlying market valuation and as a result, when risk management is applied, CFDs can be a solid trading tool.

Therefore, anyone approaching CFDs should always look to analyze what they could lose, as opposed to simply focussing on what they could gain.